Video #5 of Mo’s COVID-19 Video Updates:
Today, over 30 million people in North America are unemployed. That is more than the entire population of Australia and the largest number of people out of work in over a century. There are entire segments of the economy that have been shut down, and GDP forecasts for the entire economy to collapse 20-30% in the second quarter. We’re witnessing some of the worst economic data points and the most volatile environment we have ever seen.
And yet, North American equity markets are surging. As of this weekend, stocks have posted two of the best weeks since the 1930s and April can be among the best months for equities on record. The S&P is now basically where we were 6-8 months ago. In fact, at a current price-to-earnings ratio of 23x, we are ahead of the 19x price-to-earnings ratio were had a year ago, and well above the historic averages of 16x.
This leads many thoughtful people to ask, how can Wall Street be so disconnected from Main Street? Does this market make any sense?
The short answer is yes, and no.
Firstly, it’s important to recognize the markets rarely make sense. Blogger Ben Carlson shared that after Hitler’s invasion of Poland in September 1939, when markets opened the Dow jumped almost 10% higher. Similar, phenomena occurred for most of WWI, Pearl Harbor, D-Day and many other ostensibly precarious periods in US history. How could that be?
The reason for it is the distinction between capital markets data and traditional economic data. Economic data points, such as employment and GDP growth are generally backwards looking. On the other hand, capital markets data points, such as price of the S&P 500 and bond yields are forward-looking.
You may say, that sort of makes sense but in all previous cases, the entire economy wasn’t shuttered. Most businesses continued to be generally productive. Even if the markets are forward-looking, don’t they see that we are living in a uniquely historic time? And isn’t it obvious that near-term economic data is going to look awful?
You are correct. The second point that’s important to understand about forward-looking capital markets is that they trade on alignment to expectations. In other words, we could experience bad news (e.g. higher unemployment data, GDP drop, debt defaults, etc.), but it’s just not as a bad as the market expected it, so stocks jump higher. Conversely, we could experience good news (e.g. discovering a vaccine, more stimulus, stronger earnings, etc.), but the good news is not as good as the markets expected and stock markets tank.
You may still say. “That’s fine, but how could the markets have such rosy expectations for the future when every business I know is struggling?”
This comes back to three unique aspects to today’s markets.
Firstly, the headline price of an index isn’t representative of all publicly traded companies. Part of the reason the S&P 500 looks good is because the top five holdings in the S&P 500 – Amazon, Facebook, Apple, Google and Netflix account for roughly 20% of the index. Conversely, the 100 smallest stocks in the S&P 500 are still off 30-35%. The index looks like it’s doing well, while many within it are experiencing pain. Furthermore, other industries (e.g. travel or hospitality, etc.) and other markets (e.g. Emerging Markets) are experiencing considerably larger declines.
Secondly, we are living in an artificially suspended world. The Fed has and will throw everything at it, buying corporate debt. And the liquidity provided by the Fed and fiscal stimulus at both the federal, state/provincial, and municipal level has been significant. A lot of the valuation of US stocks may be driven by the fact that the US can throw way more stimulus at the problem than other countries.
Thirdly, the market doesn’t know anything. Many others have said that the market is micro-efficient and macro-inefficient. It can tell you the price of everything and the value of nothing. From where we sit, markets can continue to rise to new highs, can test the lows we experienced in March, or can bounce around in a volatile fashion between the two extremes.
None of us know which way the markets will move, but the longer-term divide between Wall Street and Main Street will likely continue to expand. Due to the impact public companies have on market sentiment, central banks and governments are doing everything in their power to prop them up, putting private companies at a disadvantage. The likely consequence is that on the other end of this cycle greater opportunities will exist in private equity than in public equities. And stocks will act more like derivatives than proxies for comparable business in the real economy.